Friday, November 18, 2011

The Morning Call What will Germany do?

The Market


Yesterday was pretty grim; although the DJIA (11770) did close within its intermediate term trading ranges (10725-12919) and its short term up trend (11660-12564). However, it did break below the lower boundary of the pennant pattern mentioned in yesterday’s Morning Call.

The S&P remains within its intermediate term trading range (1101-1372) but finished the day below the lower boundaries of both its short term up trend (1232-1348) and its comparable pennant formation.

This pin action activates our time and distance discipline on (1) the S&P break below its short term up trend and (2) both Average’s downside break from their respective pennant formation. Given the magnitude of those breaks, unless we get a sharp reversal today, the distance element will confirm that all three challenges as successful.

Volume was flat; breadth fell. The VIX rose but not nearly as much as I would have expected on such a big down day. Nevertheless, it is still in the upper zone of its current trading range; and that is a negative for stocks.

As dismal as all the above is, there are two factors that may (the operative word) point to a recovery today. First, today is option expiration and typically any volatility associated with it is experienced before the expiration day. Second, a check of our internal indicator reveals that in a Universe of 166 stocks, 77 did not break the lower boundary of their comparable short term up trends, 58 did and 31 were too close to call. You will recall that as volatility exploded, this indicator has been less reliable than it has historically. However, I still put substance in a reading that contradicts a single index (S&P).

GLD got whacked along with everything else. However, it remains well within its intermediate term up trend.

Bottom line: several things have happened, technically speaking:

(1) the Averages are now divergent with respect to their short term up trend. Historically, our Portfolios do nothing until this condition corrects itself,

(2) our time and distance discipline is now in effect; however, given the magnitude of the break in the S&P, if there is no recovery today, its break of the short term up trend will be confirmed--not a positive for the Market,

(3) both index busted out of a pennant formation to the downside. As I noted yesterday, if this break holds, historically that would suggest a downward trend in prices for a month or so [in this case],

(4) there are a couple of dissonant elements that could lead to a rebound today and negate (1)-(3) above: the VIX was unusually dormant in yesterday’s flush, most of the action around option expiration occurs the two days prior to expiration; and our internal indicator did not reflect the pin action of the Averages. As a result of these factors, our Portfolios will sit out today, or at least most of it, before initiating any trading moves,

(5) longer term, there is no reason to think that the lower boundary of the current trading ranges (10725, 1101) won’t provide adequate support.



More good economic data yesterday: jobless claims fell again (investors would have killed for a number like this a couple of months ago), October housing starts fell much less than anticipated and building permits surged. True the Philly Fed index was not so hot (down more than estimates); but even it had some redeeming features--the employment and future expectations elements were much better than estimates.

But investors are clearly back on the track of ignoring improving stats in favor of worrying about Europe. The intransigence of our political class (super committee) didn’t help. Yesterday’s line up of negative events included:

(1) very poor bond auctions overnight in Spain and France,

(2) rioting in Greece,

(3) a rumor that Italy could not seek help from the EFSF,

(4) the ongoing verbal battle between France and Germany as to whether the ECB will be allowed to act as the EU’s lender of last resort,

(5) the continuous reporting on the deadlock amongst the super committee over budget reform.

I have been pretty clear in my assessment of these issues, so I won’t produce another long rant session.

(1) with respect to the super committee, who would have dreamed a year ago that investors would be concerned that only $1.2 trillion was going to be cut from the budget over the next ten years? True enough that we need much more. But it’s like 100 politicians buried at the bottom of the ocean--it is a start. Indeed, if the mood of the electorate remains as irate in November 2012 as it is today, then it will be just that--a start.

(2) in my opinion, Europe boils down to one simple proposition--will Germany consent to the ECB becoming the lender of last resort (i.e. allow it to print money)? All these other headlines [a] are just manifestations of the problems that will get much worse if there is no lender of last resort, [b] will recede, at least in the short term, if there is and [c] are the result of highly vested interests relentlessly pushing the Germans to make a decision sooner rather than later.

Bottom line: the economy is improving which is to say it does not appear to be heading for a ‘double dip’.

The US political class has changed not a whit. The good news is that in an attempt to weasel on one budget deal, they made a pact that forces them to make an even more draconian budget deal. No matter how much more in cuts you (and I) want, if these morons can’t reach an agreement by 11/23, the US budget still benefits from a $1.2 trillion reduction.

That is not bad news. Indeed, I would argue that not reaching a compromise will so infuriate the electorate that it will increase the probability of a dramatic change in the make up of the political class in November 2012. That would mean we get a down payment of $1.2 trillion and a new congress to boot. The bad news scenario would be congress weaseling on the deal. But that will only increase the odds of their own demise. Net, net, in my opinion, whatever happens will not have a material impact on the Market unless congress approves a reform of the tax system as well as Obamacare--and what are the odds of that?

That leaves Europe. I have no idea how much of the disaster scenario (Germans walk and the EU unravels) is in the current price of stocks. I have said that (1) I didn’t think that the worse case would happen, and (2) even if it did, I wasn’t sure how much of the disaster scenario was being discounted.

I still think that the most likely outcome is for the Germans to relent. The reason is so simplistic as to sound naïve; and it is this: if the Germans take their marbles and go home today, they know that all of Europe is f**ked including themselves (it will crush their export business). So I think that they will conclude that it is far preferable to give the fiscally irresponsible members a reprieve but with strict fiscally disciplined strings attached--and then hope that tomorrow Europe can grow its way out of its heavy debt burden. Even assuming one country rebels and exits the EU, the financial hardship it will create for itself will stand as a huge disincentive for the rest of formerly more profligate members to follow suit.

I am not implying that such a strategy will work. It may simply postpone the inevitable. I am arguing that when the heat is most intense, the Germans will likely reason in the way that I have presented and that will at the least kick the day of reckoning down the road.

That said, I may be proven wrong in short order (this news flash courtesy of Seeking Alpha):

Germany preparing for defaults by large eurozone nations. Germany is preparing for bankruptcy by eurozone countries that are too big to be bailed out, a leaked document from the country’s foreign ministry reveals. Officials are also planning for a European Monetary Fund that would take ailing countries into receivership and run their economies, and for closer political integration.

That still leaves the question, if I am wrong as the above implies, how much downside is left? Clearly, this problem has been around long enough that investors have had time to digest it, make assumptions about the downside and factor those into valuations. So to me, the only way we have significant risk from here is if, as an article I linked to a few days ago concludes, investors have bet most of their money on that the worst case simply won’t happen.

All that said, I don’t have a clue what the Germans will do nor is there any way to know exactly what investors have or have not discounted.

However, what I do know is that our Buy/Sell Discipline has worked through all kinds of Markets; and I have never allowed my opinion on the Market or the economy to stand in the way of making/not losing money. So if we are truly facing a worse case scenario, our Sell Discipline will keep our losses relatively small.